Randall Kroszner, a professor at the University of Chicago Booth School of Business and a former governor of the U.S. Federal Reserve Bank, discussed the fragility of the banking system and the role of monetary policy during fiscal crises at the 65th CFA Institute Annual Conference in Chicago yesterday. Kroszner joked at the start of his session that the U.S. credit crisis was “his fault,” since he served as a Fed governor from 2006 to 2009. Fortunately for the audience, Kroszner’s current occupation allowed him to speak off script — a luxury he did not have during his tenure at the U.S. central bank.
Kroszner opened his discussion by noting that leverage, liquidity, and interconnectedness make the banking system extraordinarily fragile as compared to other industries. The banking model is to borrow short and lend long, which creates a funding mismatch, and banks rely enormously on short-term financing, which can change very quickly. In addition, he pointed out, any nonfinancial institution with a leverage ratio of 10:1 is far too overleveraged. But a bank with the same leverage is extremely well capitalized. The problem was that just ahead of the crisis, many banks only had 3–4% core capital, and that left very little room for asset volatility.